And Here’s Why Gold Will Remain Money

One of the longest-running myths in financial markets is going to damage a lot of portfolios: the myth that central bank money printing — in the context of a modern banking system — hikes the value of stocks.

Many academics still think printing lots of money — which is thought to permanently increase stock prices — will lead to some sort of trickle-down economy phenomenon. Ben Bernanke said as much in his famous November 2010 Op-Ed in The Washington Post: “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Since then, the S&P 500 has rallied from 1,200 to 1,430, mostly on the belief that stocks are a good substitute for bonds. Printing from the Fed and other central banks has front-loaded returns. Front-loading returns means the potential market gains will be depressed. In other words, the Fed’s actions have temporarily pushed stock prices above intrinsic value, and when the Fed stops money printing, stocks could quickly fall back to intrinsic value.

Yale professor Robert Shiller created the “Shiller P/E ratio,” which is the most-robust measure of the intrinsic value of the broad stock market. The Shiller P/E ratio is calculated as follows: Divide today’s S&P 500 index by the average inflation-adjusted earnings from the previous 10 years. I look at 10 years of earnings and cash flow data in researching stocks to get a feel for how earning might look in the future. Most investors remain too focused on the quarter-to-quarter minutiae, which often leads to surprises at turning points in the earnings cycle.

The Shiller P/E of the S&P 500 is currently 23 — 50% higher than its long-term average. The average Shiller P/E ratio since 1880 is about 15. A move back to the average would take the S&P 500 back to 930. A move to bear market low valuations would take the S&P 500 back to roughly 400. Right now, it’s 1,432.

The Fed can’t grow the intrinsic value of stocks. Companies can do that only by earning returns above their cost of capital.

In the coming quarters, many companies that had been earning returns above their cost of capital will be earning lower returns. Free cash flow will follow returns lower. Look at Intel’s latest revenue warning; look at FedEx’s earnings warning. Profit margins have peaked in many industries. Manufacturing companies exporting to Europe and China will continue to suffer. Apple can hold neither the stock market nor the economy up.

Meanwhile, household budgets out in the real world are straining to the breaking point. This morning’s data showed the US labor force participation rate at a terrible 63.5% — the lowest in 31 years.

So Ben Bernanke is responding to this silent crisis the only way he knows how…by pushing repeatedly on the “print money” button at the Federal Reserve. He calls is “quantitative easing,” or QE. And it’s my bet that QE3 is coming soon to a nation near you. With each successive round of quantitative easing, demand for gold and other stores of value will rise and demand for stocks will weaken.

As I observed in this column last Friday, “Fed officials have been all over the media for weeks, laying the groundwork for a third round of quantitative easing. By preparing markets for QE3, the Fed refuses to let real-world evidence get in the way of its beloved theories…Perhaps once the global paper money system is restructured, involving some sort of gold standard, sanity will return to the Fed and other central banks. Until we see more signs of sanity, hold a core position in gold, silver, and precious metal mining stocks. These asset classes will be the prime beneficiaries of future printing.”

Dan Amoss, CFA, is a student of the Austrian school of economics, a discipline that he uses to identify imbalances in specific sectors of the market. He tracks aggressive accounting and other red flags that the market typically misses. Amoss is a Maryland native, a graduate of Loyola University Maryland, and earned his CFA charter in 2005. In spring 2008, he recommended Lehman Brothers puts, advising readers to hold the position as the stock fell from $45 to $12.

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